BLOG

  • IAP, LLC

Inflation Rears Its Ugly Head



Headlines about inflation have been abundant lately. Whether it be the price of gasoline for your car or an increase in your grocery bill, it seems everyone is feeling the pain of inflation. Why are we experiencing it now and what do we do about it?


INFLATION BASICS

First, some basics. The phenomenon of rising prices (inflation) is nothing new. Prices of goods and services have risen about 3 percent per annum since our economic records began tracking such a thing almost 100 years ago. Increases in prices often results from too much demand for a good or service. Consider home prices in the last two years-demand has risen dramatically while supply is limited. So, the sellers can demand more dollars in exchange for their home.


The economic recovery from the pandemic was assisted by significant government spending and “accommodative” Federal Reserve policies. The recovery worked very well, but has likely stoked our recent inflationary times. Rising wages, low interest rates, and some pent-up demand for goods and services all factor into higher prices for the scarce goods and services consumers want. Interruptions in the supply chain hasn’t helped keep prices in control-the longer it takes to get some goods increases demand, and prices, for like products.


INFLATION AND INVESTING

What can investors do about inflation? Well, the number one reason to invest in equities is to offset the effects of inflation. That seems to have worked well over time, as the long-term rate of return on stocks has been about 7 percent over inflation. Fixed income investors, however, are unlikely to keep up with inflation when it strikes unexpectedly as it has. Bonds with fixed interest rates and long maturities may have been purchased to yield a rate that exceeded inflation expectations when they were bought. But as inflation increases, investors can’t adjust those fixed interest rates to compensate for the changes in the market.


There are some available fixed income investments that adjust, on the fly, to changes in inflation. Two of the most popular, and recently in the headlines, are TIPS (Treasury Inflation Protected Securities) and I Bonds (a US savings bond).


TIPS

TIPS are US Treasury bonds, considered the safest in the world. The interest coupon rate on the TIPS bond is set at issuance (several times per year). The inflation protection comes in the form of a change in the principal value of the bond when the Consumer Price Index (CPI) increases. For the past many years, the interest coupon rate on the TIPS issued has been very low-under 1 percent. Since inflation hasn’t been significant in the last ten years, owning TIPS has not been very productive. Lately, however, the inflation component has been healthy enough to produce a nice hedge against inflation by owning these bonds. But the hard part would have been deciding to buy them when inflation was low (below 2%) and the coupon was also low (under 1%). Further, the prices on the bonds were such that buyers were getting 1 percent less than inflation. Now the prices are such that buyers get actual inflation as a return. Warning-owning this in a tax-deferred retirement account is preferred over a currently taxable account.


I BONDS

I Bonds are a form of a US Savings Bond. These bonds are issued every 6 months with a coupon rate, currently zero, and a promise to pay interest in the amount of the change in the CPI. So, lately the rates have been spectacular-7.12% for November 2021 to May 2022. The rate for the six months beginning May 2022 is 9.62%! The rate adjusts every six months while the bond is outstanding for its 30-year term. The down sides to the I Bonds are: 1) you can only buy $10,000 of bonds per year per taxpayer (you must buy directly from the Treasury at www.treasurydirect.gov-not through a brokerage firm), 2) you must hold them for one year, and if you redeem within 5 years, you lose three months of interest.


THE FUTURE OF INFLATION

How long might the recent inflationary times last? Who knows. But it’s unlikely that we are in for a period like the 1970s that had its own myriad set of circumstances that are dissimilar to today’s situation. The Federal Reserve has promised to increase interest rates to get inflation under their target of 2%. But will that cause a recession? Maybe. But, compared to other pre-recession times (e.g. the Financial Crisis from 2007-2009), banks, corporations and consumers are in much better financial positions. Unemployment is very low, net worth of individuals is at an all time high, housing loans were almost all refinanced at very affordable rates, and banks have better capital positions and tougher lending standards.


The one silver lining for retirees is that Social Security checks got boosted by 5.9% for 2022 due to the CPI increase. It’s likely they’ll get a similar or higher boost for 2023.